Tag: Confirmation

A simple proposition—that secured lenders are entitled to receive payments with a present value at least equal to the amount of their claim—has proven surprisingly difficult to apply as courts have pondered whether to follow a “formula approach” or a “market approach” to establish an appropriate “cramdown” interest rate. (A primer is available here if you are new to the debate.)

Secured lenders have scored a significant win in the recent Second Circuit decision in the Momentive case, In re MPM Silicones. Siding with the Sixth Circuit, the Second Circuit has decided that the prevailing market rate for comparable debt should be used—if there is an efficient market for such debt—and that the formula approach should be used only if no efficient market exists.

Market-Rate Schmarket-Rate… What’s the Big Deal?

Theoretically, whether you build up from a base rate and fully adjust for the characteristics of a loan or whether you consider comparable market loans to determine an appropriate interest rate, you should end up at roughly the same place. In reality, however, courts applying a formula approach have approved interests rates that are lower than a market rate approach would support… sometimes absurdly so.

By way of analogy, consider an ordinary real estate valuation. A real estate appraiser will consider different valuation methods—market comparables, replacement cost, and income capitalization. These three approaches will often provide different values for a property, so an appraiser must reconcile the varying results. Sometimes differences are minor. But depending on the property and the appraisal’s objective, one of the approaches may be more suitable than the others.

Similarly, in the bankruptcy context, the formula approach and market approach can support different interest rates, and one of the approaches may be more suitable in Chapter 11 than the other. And uncertainty over which approach to apply in Chapter 11, combined with courts’ self-imposed reluctance to impose a risk premium of more than 1-3% under the formula approach, has spawned significant litigation with very real consequences.

The Original Momentive Rulings: The Formula Approach

Momentive, one of the world’s largest producers of silicone products, filed a Chapter 11 bankruptcy case in 2014. At the time, it had two outstanding series of senior lien notes, one in the principal amount of $1.1 billion with an 8.875% interest rate and the other in the principal amount of $250 million with a 10% interest rate. Momentive’s plan proposed, in essence, that these claims would be satisfied with long term replacement notes with a below-market rate of interest based on the “formula” approach, e.g., 4.1% and 4.85%, respectively. This represented a total reduction of approximately $70 million in the amount of interest payments over the life of the notes.

The lower courts approved this plan, expressing concern that a market rate of interest would “overcompensate” cramdown lenders. Why? Because market rates include transaction costs and profits indicative of new loans. By following the formula approach, the lower courts could disregard these add-ons and felt they could truly “put the creditor in the same economic position that it would have been in had it received the value of its claim immediately.” The decisions also reflected a general tendency to limit risk adjustments to a range of between 1-3%. The result was the approval of new notes that bore interest rates far below the original issue interest rates and current market rates, and an appeal to the Second Circuit.

The 2nd Circuit Reverses Course: A Market Approach Is Preferred

The Second Circuit rejected the lower courts’ reasoning. Disregarding available efficient market rates, it stated, would be a major departure from long-standing precedent dictating that the best way to determine value is exposure to an efficient market.

“[W]here, as here, an efficient market may exist that generates an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length, we conclude, consistent with footnote 14 [of Till], that such a rate is preferable to a formula improvised by a court.”

And what is an efficient market? In keeping with the Fifth Circuit, the Court described it as one where, for example, “they offer a loan with a term, size and collateral comparable to the forced loan contemplated under the cramdown plan.” The Second Circuit suggested that an efficient market might exist for notes similar to the replacement notes at issue in Momentive, but it remanded the question to the Bankruptcy Court to decide.

A Cliffhanger Ending…

Will Judge Drain decide that an efficient market exists on remand?

Judge Drain’s bench ruling suggests he may not, as he noted that “it is highly unlikely that there will ever be an efficient market that does not include a profit element, fees and costs, thereby violating Till’s first principles, since capturing profit, fees and costs is the marketplace lender’s reason for being.”

But the Second Circuit opinion could be read to downplay his concerns, as it approvingly cited the testimony of the first lien noteholders’ expert, who testified that when notes are priced at the market rate noteholders are “being compensated for the underlying risk that they are taking” and not for any “imbedded profit.”

Stay tuned to find out what happens in Episode 4: The Cramdown Rematch.

The Bottom Line

Meanwhile, the Second Circuit’s opinion significantly reduces uncertainty around the application of Till’s formula rate to Chapter 11 cramdown notes in the Second Circuit and appears to be good news for secured creditors, who have been facing threats of cramdown with below-market take-back debt in restructuring negotiations, and a loss for debtors and unsecured creditors who might benefit by extracting value at their expense. Although it is also possible that the two-step approach adopted here could simply shift litigation efforts to focus instead on whether there exists an efficient market in the first instance.

The Bankruptcy Code allows a debtor to confirm—or cramdown—a reorganization plan over creditors’ objections if certain criteria are met. One requirement is that, if secured claims are to be paid over time, the secured creditors must receive cash payments with both a nominal value and a present value at least equal to their claims. This recognizes the economic reality that $100 today is worth more than $100 paid in $10 increments over 10 years.

Determining if the nominal value of a payment stream equals the face value of a claim is “attorney math,” e.g., simple addition. But to create a future payment stream with the same value as a lump sum payment today requires establishing an interest rate that reflects the characteristics of those deferred payments—e.g., investment risk, duration, time value of money, etc. If the interest rate is correct, then the discounted present value of the payment stream equals the nominal value of the claim today. Simple, right? (If you are lost, try this explanation from Math Is Fun or a refresher from the Harvard Business Review.)

But how do you come up with an appropriate interest rate? The legal brains who wrote the Bankruptcy Code provided no practical, mathematical guidance, leaving lawyers and judges to muddle through on their own, or with the help of valuation experts. Confusion and litigation ensued.

The Formula Approach

To illustrate, in 1998 an Indiana couple bought a used truck for about $6,000. They financed the purchase at a 21% interest rate, ultimately ending up in bankruptcy owing over $8,000 on an old truck worth about $4,000. The couple wanted to keep their truck and pay the lender principal plus interest at what they felt was more reasonable rate of 9.5%. But the finance company held out for 21%, which it felt was needed to compensate for the high risk loan. The fight over the truck, and the interest rate, ended up before the Supreme Court in the seminal case Till v. SCS Credit Corp.

The Supreme Court adopted a “formula approach” for coming up with an interest rate, which people also refer to as—wait for it—the Till Method. Under this approach, you build a cramdown interest rate from the ground up by starting with the prime rate and then adjusting for factors such as the debtor’s circumstances, the nature of the proposed “loan”, and the duration and feasibility of the debtor’s plan. Add that all together and, viola, you have your cramdown interest rate.

But Till leaves a lot of unanswered questions. (Why start with the prime rate and not a risk-free treasury bill, you might be wondering?) In a cliffhanger footnote, the Supreme Court itself pondered whether Till’s formula approach should be applied in the very different context of Chapter 11 cases, which often involve large commercial loans negotiated between sophisticated parties. That is an excellent question that a lot of bankruptcy professionals would like an answer to.

The Efficient Market Approach

While some cases have applied Till’s formula approach in the context of Chapter 11 cases, others have adopted a so-called “efficient market” approach. The question these courts grapple with is what interest rate lenders in the market would charge on a similar new loan. If an efficient market exists for the type of “loan” in question, in theory, you can look to the markets to tell you an appropriate interest rate that will compensate the lender for risk and the time value of money. While that is theoretically sound, one of the real world difficulties is that cramdown plans are inherently coercive, and there is no market for coerced loans.

Other Theoretical Approaches

Other approaches that are possible include a coerced loan approach, a presumptive contract approach, or a cost of funds approach. The goal of all of these methodologies is the same, e.g., to create a concrete framework for applying present value theory. For an in depth, academic discussion of all of these approaches, Northwestern University Law Review has published an excellent article.

No Easy Answers…

What is clear is that establishing a cramdown rate in a Chapter 11 case is going to be significantly more complex than simply applying a few qualitative adjustments to the prime rate or referencing some sort of “Blue Book” of cramdown interest rates. To establish an appropriate cramdown interest rate requires knowing the legal jurisdiction you are in and the latest cases on the issue, and often, involving a financial expert to support your position.

Over and over again the same story plays out. A case files. A lender carves-out a small amount from its collateral to fund Committee professionals and an investigation of the lender’s position. That amount is inadequate, and the Committee blows past the carve-out amount.

That’s just what happened in Molycorp, where the DIP financing agreement contained a typical $250,000 carve-out provision for the Committee’s investigation of claims.

After an extensive discovery process resulting in asserted claims, mediation, and a global settlement, the court confirmed a consensual plan and the Committee’s counsel requested payment of $8.5 million in fees.

The lender objected, arguing that the $250,000 carve-out was an absolute cap on fee payments. The Committee responded that while the carve-out may have limited its fees in an administratively insolvent case, it was irrelevant in a case with a confirmed chapter 11 plan. The Delaware court agreed.

The court explained that “[t]he carve-out is . . . an agreement by the secured creditor to subordinate its liens and claims to certain allowed administrative expenses, permitting such professionals’ fees to come first in terms of payment from the estate’s assets. . . . [W]hen there are insufficient unencumbered assets to pay professionals’ fees and no plan has been confirmed, professionals’ only recourse is the carve-out.”

Here, however, a plan was confirmed. In that context, Bankruptcy Code section 1129(a)(9)(A) requires that allowed administrative claims be paid in cash (or as otherwise agreed) on the plan’s effective date. And nothing in the carve-out language suggested that the fee cap would prohibit the allowance of administrative fees upon plan confirmation.

“If the secured parties desire confirmation, the administration claims must be paid in full in cash at confirmation even it if means invading their collateral.”

A World of Caution….

The court contrasted the carve-out at issue with one in a DIP financing order entered in another case that stated: “[n]otwithstanding anything to the contrary therein, and absent further Order of the Court, (i) in no event during the course of the Chapter 11 Cases will actual payments in respect of the aggregate fees and expenses of all professional persons retained pursuant to an Order of the Court by the Creditor’s Committee exceed $450,000 in the aggregate (the ‘Creditors’ Committee Expense Cap’) … (iii) any and all claims (A) incurred by the Creditor’s Committee in excess of the Creditor’s Committee Expense Cap or (B) incurred by any professional persons or any party on account of professional fees and expenses that exceed the applicable amounts set forth in the Budget shall not constitute an allowed administrative expense claim for purposes of section 1129(a)(9)(A) of the Bankruptcy Code.” At the same time, the court offered “no opinion as to whether it would approve a DIP order containing [such] provisions” had it been presented ….

Friday night I hosted a Día de los Muertos party. Naturally, I invited other bankruptcy attorneys. And when you mix lawyers and tequila, things can get pretty crazy. It wasn’t long before someone was well into an animated story about his Absolutely Worst Day Ever as a Lawyer. Now that its Monday morning and we’ve all sobered up, here’s a recap of his Very Bad Day and the surprise reversal of In re Entz-White that caused it.

Last Week, Debtors Could Avoid Accrued Post-Default Interest in the 9th Circuit by Curing an Underlying Default…

My friend (let’s call him “Roberto”) was representing a debtor that had fallen behind on its loan and was facing insurmountable default interest. If it could avoid the default interest and other late penalties, it could otherwise cure its defaults, restore its loan to its original terms, and successfully reorganize. “No problem!” Roberto had said. And he took the case on a contingency.

Roberto was right. In re Entz-White Lumber & Supply, Inc., decided back in 1988, held that when a debtor cures a default it may avoid all consequences of the default, including higher post-default interest rates. In other words, it may both repay arrearages at the lower, pre-default interest rate and return to pre-default conditions, including pre-default interest rates, for the remainder of the loan obligation.

Mechanically, it works like this. Section 1123(a)(5)(G) of the Bankruptcy Code requires that a debtor’s plan of reorganization adequately provide for its implementation, including by “curing” any default. The Bankruptcy Code contains a long list of definitions. Oddly, “cure,” used throughout the Bankruptcy Code, is not one of them. To fill in that gap, the Ninth Circuit adopted the Second Circuit’s definition of cure, e.g., curing a default means taking care of the triggering event, thereby nullifying all of its consequences, including default penalties such as higher interest.

Roberto had relied on Entz-White in charting a path forward for his client. The case was on the verge of confirmation, and he was on the verge of earning his contingency fee.

…. But on Friday, the 9th Circuit Issued a New Opinion Overturning Its Prior Ruling

On Friday, instead of celebrating, Roberto was shooting tequila in my living room and crying into his cerveza.

In In re New Investments, decided earlier that day, the Ninth Circuit overturned its opinion in Entz-White, holding that Bankruptcy Code Section 1123(d) voided Entz-White’s rule that a debtor who proposes to cure a default may avoid a higher, post-default interest rate in the loan agreement. The Ninth Circuit reversed the bankruptcy court’s underlying order, which had confirmed a Chapter 11 plan based on Entz-White… and simultaneously upended my friend’s pending case as well.

Section 1123(d), which was enacted in 1994, well after Entz-White was decided, states that:

Notwithstanding subsection (a) of this section and sections 506(b), 1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to cure a default the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.

Following is a brief summary of the case and the court’s rationale.

1. Evaluating Applicable (Washington State) Nonbankruptcy Law

In New Investments, the debtor had defaulted on a real estate loan, thereby triggering a default-interest provision. It then filed for bankruptcy protection to avoid foreclosure. Its plan was to sell its property and then use the sale proceeds to payoff the loan – thus curing the default – at the pre-default interest rate. The lender objected, pointing to its contractual rights under a promissory note that called for payment of a higher interest rate (equating to approx. $670,000) upon default. The loan agreement was governed by Washington state law. The Ninth Circuit concluded that Washington allows for a higher interest rate upon default when provided for in the loan agreement. See Wash. Rev. Code Ann. Section 61.24.090(1)(a). Thus, it held that cure, as determined under the parties’ contract and applicable state law, required payment of accrued default interest.

The Ninth Circuit stated that the plain language of Section 1123(d) compelled its decision. As with all plain-language arguments, there is nothing to analyze here. You can read Section 1123(d) and decide for yourself whether you agree.

3. Surprise! The Legislative History Indicates This Result May Be Unexpected

In case you disagree with the Court’s plain reading of the statute, the Ninth Circuit also looked to the statute’s legislative history and stated it would not help New Investments. Essentially, the Ninth Circuit concluded that Congress had a very particular, and different, purpose in mind when it enacted Section 1123(d) and that it may not have anticipated all of the statute’s consequences. But that, it said, is not a good enough reason to ignore the statute’s plain meaning.

What was Congress trying to do when it enacted Section 1123(d)? The legislative history indicates Congress was primarily concerned with overruling the Supreme Court’s decision in Rake v. Wade, which had stated that, in order to cure a default, a Chapter 13 debtor would have to pay interest on his arrearages even if the underlying loan agreement did not provide for it. Congress was concerned that Rake v. Wade provided an unbargained-for windfall for creditors and enacted Section 1123(d) to “limit the secured creditor to the benefit of the initial bargain.” Congress, the Ninth Circuit acknowledged, may not have anticipated how Section 1123(d) would be interpreted in other contexts.

But the Ninth Circuit felt that its holding, if unanticipated, would not be inconsistent with Congressional intent. In holding the secured creditor to the benefit of its bargain, Congress had said that a cure pursuant to a plan should “put the debtor in the same position as if the default had never occurred.” That, it said, is consistent with holding both parties to the benefit of their bargain and with the concept of cure generally (which it conceeded Section 1123(d) did not alter or attempt to define).

The Ninth Circuit tacitly recognized that its holding will make it more difficult for some debtors to reorganize, undermining the Bankruptcy Code’s goals of offering a fresh start to honest debtors. But it felt that its decision strikes an appropriate balance between the interest of debtors and creditors.

4. The Interpretation of Cure in Section 1123 is Consistent With the Concept of Unimpairment

The Ninth Circuit also stated that its ruling in New Investments would be consistent with the concept of unimpairment under the Bankruptcy Code. To render a creditor “unimpaired” such that it cannot object to a debtor’s plan, the debtor must cure defaults and may not “otherwise alter the legal, equitable, or contractual rights” of the creditor. One of these rights is post-default interest.

Future Default Interest Differentiated

It is worth noting that the New Investments decision focuses on the treatment of accrued, default interest when a debtor is calculating required cure amounts. But once default interest or other penalties are paid and a default is therefore cured, the debtor can still return to pre-default conditions as to the remainder of the loan obligation.

Judge Berzon’s Dissenting Opinion

In a dissenting opinion, Judge Marsha S. Berzon wrote that neither Section 1123(d) nor any other provision of the Bankruptcy Code provides a definition of “cure” contrary to the one announced in Entz-White.

As for the majority’s conclusion that Congress displaced Entz-White when it passed Section 1123(d)? Judge Berzon argues at length that this conclusion is not supported by either the plain language of the statute or its legislative history. Instead, Judge Berzon argues that the Court should not read the Bankruptcy Code to erode past bankruptcy practice absent a clear indication that Congress intended such a departure.

For those of you watching for a ruling from the Supreme Court in In re Jevic, mark your calendars! Oral argument has been set for Monday, November 28, 2016.

If you haven’t been tracking the case, this is an excellent time to get up to speed.

Simply put, the Supreme Court granted certiorari in Czyzewski v. Jevic Holding Corp. to decide whether “structured dismissals” can be used to wrap up a Chapter 11 bankruptcy case. A structured dismissal is a creative (or, depending on your perspective, inappropriate) solution that bankruptcy lawyers have come developed to resolve a case–often following a sale of substantially all of the company’s assets–without the delay and expense of a formal chapter 11 plan process but with more elegance and closure than creditors would have if the case were simply dismissed. The problem? Nothing in the Bankruptcy Code contemplates “structured dismissals.” And often they include “gifting” of assets from a secured creditor’s collateral to various unsecured creditors. Unhappy creditors who are left empty-handed have complained that these agreements violate the priority of creditor distributions called for under Section 507 of the Bankruptcy Code.